Morningstar Advisor - April/May 2009 - 56

Undiscovered Managers Vineer Bhansali manageable. PIMCO says that the tail-risk hedging strategy adds 25 to 50 basis points to the expenses of running the fund. Another common objection to tail-risk hedging is the assumption that it needs to identify the exact sources of financial market stress to be effective. Very few in the investment industry were wary of the subprime sector before 2007, and virtually no one can predict something like a terrorist attack. Bhansali argues that he doesn’t need to know the precise catalyst of a crisis before it occurs. His hedging approach does not target specific sectors of the market, but rather it works at the level of the macro effects that result from the crisis and the policy responses to it. “While the origins of financial crises can be very distinct and hard to predict,” he says, “they all tend to have similar macro consequences. For macro hedges to be successful, we don’t need to correctly predict exactly which tail events will happen. We simply need to protect against the range of responses to those events.” At the Global Multi-Asset fund, this protection could be acquired through a variety of methods, such as by purchasing short-term Treasuries or eurodollar futures. Both tend to rally during market crises, as capital seeks a flight to quality. Similarly, certain currencies, such as the U.S. dollar, Japanese yen, and Swiss franc, have traditionally been seen as safe havens. Moreover, the fund will also use option-like approaches on credit indexes, using deeply out-of-the money segments of the CDX and iTraxx. Or it will use managed-futuresstyled strategies. Beyond these approaches to hedging risk, the managers will simply dial down the portfolio’s level of risk when they think the market isn’t offering attractive valuations or adequate compensation for risks. Unknowns and the Unknowable PIMCO Global Multi-Asset PGAIX $12K 11 10 9 Nov 08 Dec 08 Jan 09 Dow Jones Moderate Port Feb 09 Mar 09 out there, Bhansali says. He refers to 17thcentury French philosopher Blaise Pascal’s famous propositions regarding the existence of God. Pascal’s wager suggests that although we lack knowledge and proof of God’s existence, the best bet is to believe, given the cost-benefit analysis in place for Pascal. Similarly, Bhansali says, tail-risk hedging encompasses many uncertainties, but it is best to recognize that and protect oneself in the best possible manner. Bhansali says that he also understands his limitations. The tools he uses to evaluate risk and determine how to hedge against it are just that, merely tools. They are not to be overly trusted or relied upon in all situations, he says. As an aircraft pilot, and underscoring his cautious style, he mentions an old adage that counsels aviators: In the event that an instrument malfunctions during flight, cover the instrument, because you’d rather not have it at all than mistakenly rely on it. In the end, while this approach is very new to the open-end mutual fund universe, its initial results look promising. The Global Multi-Asset fund and the RealRetirement target-date lineup, both launched last year in the midst of the financial crisis, have held up well, in large part because of Bhansali’s tail-risk hedging. It remains to be seen how the approach works in various environments, but Bhansali is already looking to the next possible crisis— an unexpected, sharp jump in inflation down the road—and is protecting his portfolios appropriately. He admits that it’s a fairly unlikely scenario right now, but surely his shareholders are glad that he has it on his radar screen. And should that inflation come, we wouldn’t bet against Bhansali beating out his unprepared rivals. K Lawrence Jones, a contributing editor of Morningstar Advisor, is an associate director of fund analysis with Morningstar. Nov-08 Category World Allocation Dec-08 Jan-09 Expense Ratio (%) 1.55 Feb-09 Mar-09 Morningstar Rating Not rated Minimum Investment $1,000 Data as of Feb. 28, 2009. Since Inception Ttl Rtn (%) –7.53 financial markets have experienced significant shocks roughly every five to seven years. He points to events that have occurred just in the past 12 years: the Asian financial crisis in 1997; the Russian debt default and the collapse of hedge fund Long Term Capital Management in 1998; the tech-stock bubble burst and consequent recession from 2000 to 2002; the 9/11 terrorist attacks; and the current financial crisis, which began in early 2007 and has resulted in extraordinary financial market stress, unprecedented government response, and threatens to end in a potentially deep and protracted recession. Instability characterizes modern capitalism. “The question shouldn’t be whether you can afford to hedge, but whether you can afford not to,” Bhansali says. Based on estimates for PIMCO Global Multi-Asset Fund, which is run by Bhansali, El-Erian, and Curtis Mewbourne, the costs are Attempting to gauge improbable risks and protect portfolios against them inevitably leads one to humility. They are too many unknowns 56 Morningstar Advisor April/May 2009

Morningstar Advisor - April/May 2009

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